On May 1, 2019, the second tranche of proposed regulations related to Opportunity Zones (the “Proposed Regulations”), which are designed to incentivize taxpayers to defer capital gains through qualifying Opportunity Zone investments as contemplated under the Section 1400Z-2 of the Internal Revenue Code (the “OZ Statute”), were published in the Federal Register. As a reminder, the Opportunity Zone program is a place-based incentive, designed to attract investment capital in low-income communities throughout the United States (including, the District of Columbia and U.S. territories). The first tranche of proposed regulations and other clarifying guidance related to the implementation of Opportunity Zones, which focused primarily on real estate, was released on October 19, 2018, as described in our previous post (several terms used below are defined and described in the previous post).
The Proposed Regulations pave the way for use of the Opportunity Zone program by operating businesses and, among various other clarifications, provide answers to several open questions concerning real estate investments. The Proposed Regulations also introduce several new concepts and tools to assist with the implementation of the Opportunity Zone program, including the allowance of property to be contributed to a Qualified Opportunity Fund (a “QOF”), certain grace periods for deployment of capital, and a variety of guidelines for property leased by a QOF or a Qualified Opportunity Zone Business (a “QOZB”). To read more about the requirements of a QOF and a QOZB, see our first and second posts.
The team of Opportunity Zone attorneys at Maynard Cooper has been actively assisting clients in the investment of eligible gains in QOFs, formation and structuring of QOFs and QOZBs, qualifying real estate projects and businesses for Opportunity Zone benefits, and all other aspects of utilizing the Opportunity Zone program. In the course of our experience advising clients on Opportunity Zone transactions, we have been fielding a wide array of questions since the enactment of the OZ Statute from fund managers, real estate investment companies, private equity investors, real estate developers, business owners, economic developers, municipal leaders, and other stakeholders on a host of complex issues regarding Opportunity Zones.
The Proposed Regulations answer several of those questions, including the following:
- If an investor makes an eligible gains investment in a QOF, how long does the QOF have to invest in OZ Business Property before being subject to the 90% Asset Test? Generally, a QOF must make investments in OZ Business Property in order to meet the 90% Asset Test within the first 6 months after formation and on a semi-annual basis thereafter. However, under the Proposed Regulations, cash investments made in a QOF may be excluded from the 90% Asset Test for a period of 6 months following the date of the investment.
- The Proposed Regulations create the ability for an investor to contribute property to a QOF. How is the contribution of property to a QOF treated differently than cash? If a taxpayer has eligible gains, he or she may choose to contribute property to a QOF in lieu of contributing cash. However, there are certain caveats associated with using a property contribution rather than cash. First, in a typical contribution transaction that does not trigger gain or loss for tax purposes, if the contributed property is an appreciated asset, the contribution will be treated as a “mixed investment” in which the amount of the taxpayer’s basis in the asset may be considered an investment of eligible gains and the appreciation with respect to the asset will be treated as a non-qualifying investment in the QOF. If the contributed property is not appreciated, the full amount of the taxpayer’s basis in the asset may qualify as an investment of eligible gains in the QOF. Second, certain aspects of the Proposed Regulations are unclear in their application to contributed property – for example, the Proposed Regulations do not specify whether contributed property can qualify as OZ Business Property in relation to the 90% Asset Test for QOFs and the 70% Asset Test for QOZBs.
- Can an investor use eligible gains to acquire a QOF interest from another person? Yes. The Proposed Regulations introduce the ability for an investor with eligible gains to invest such gains in a QOF by purchasing an interest in a QOF from another taxpayer (as opposed to a direct issuance of the interest). The holding period of the purchaser starts on the date that the QOF interest is purchased.
- How are carried interests treated under the Opportunity Zone rules? Carried interests, profits interests, promote interests and other interests in a QOF that are acquired in exchange for services are not eligible for Opportunity Zone benefits. If a taxpayer also makes a contribution in exchange for an interest in a QOF, the taxpayer’s investment will be split into qualifying and non-qualifying interests based on the amount of the contribution and the profits allocations to each interest.
- If a QOF or QOZB sells an asset prior to the 10-year anniversary of the investment, are the QOF investors taxed on the gains resulting from the sale? Yes. The sale of an asset by a QOF or QOZB will be treated in accordance with general income tax rules. In the case of an entity taxed as a partnership, taxable gains and other tax attributes will flow through to the investors. Further, if the sale occurs prior to December 31, 2026, it may also cause an “inclusion event” (as described below). For Opportunity Zone compliance purposes, a QOF has a 12-month grace period in which it may reinvest the sale proceeds in OZ Business Property if the proceeds are continuously held in cash or cash equivalents.
- What are “inclusion events” described in the Proposed Regulations, and how do they affect a QOF investor’s investment? The Proposed Regulations establish a list of “inclusion events” that trigger the taxation of part or all of an investor’s deferred gains, such as the receipt of distributions in excess of basis, certain reorganizations causing a transfer of an investor’s QOF interest, and transfer of a QOF interest by gift. A detailed list and explanations with respect to the inclusion events is beyond the scope of this blog post.
- How are OZ benefits affected if distributions are made to QOF investors in excess of their basis? The receipt of a distribution by a QOF investor from a QOF (that is taxed as a partnership) is an “inclusion event” under the Proposed Regulations. The distribution will cause the recognition of deferred gain in the amount the distribution exceeds the investor’s basis and, correspondingly, a basis increase in the amount of the deferred gain recognized by the taxpayer. The Proposed Regulations provide that the effects of the “inclusion event” are calculated prior to the tax consequences of the distribution under general partnership tax rules. For example, if an investor had capital gains of $100 that he or she invested in a QOF, the initial tax basis in the investment is zero. If, in year 2 of the investment, the QOF distributes operating cash flow in the amount of $5, but did not realize any taxable income, the investor would have an inclusion event and must recognize $5 of his or her initial capital gains (the investor’s basis would be increased by $5). Then, the partnership rules would be applied to decrease the taxpayer’s basis back to zero from the receipt of the distribution.
- How does the new asset election, introduced by the Proposed Regulations, affect the exit possibilities for QOZBs and QOFs? With respect to a QOF taxed as a partnership or Subchapter S corporation, the Proposed Regulations expand the 10-year basis step-up election to allow for single assets of a QOF to be sold without requiring a QOF investor to sell his or her interest in the QOF. However, there are a couple of caveats with making the election with respect to a single QOF asset. First, the election is limited to the capital gain that is reported on an investor’s K-1. In contrast, if an investor sells his or her interest in a QOF, the election applies to all built-in capital gain and ordinary income items (as determined under the partnership tax rules) of the QOF, such as depreciation recapture. Second, the Proposed Regulations did not extend the election to the QOZB level. Consequently, if a QOZB sells an asset, it is unclear whether a QOF investor would be able to make the election for the capital gain that flows through to his or her K-1 from the QOF.
- How long does a QOZB (that is an operating business) have to spend cash received from a QOF investment? Generally, the timing constraints are dictated by the 70% Asset Test – a QOZB must meet the 70% Asset Test on the date of investment (existing entities qualifying as QOZBs) or for 90% of the QOF’s holding period (newly formed QOZBs). However, the Proposed Regulations extend the 31-month working capital safe harbor, previously only available for real estate projects, to operating businesses. Additionally, the Proposed Regulations authorize the use of multiple overlapping or sequential applications of the 31-month working capital rule, allowing for significant flexibility for operating businesses to spend capital as long as the QOZB meets the safe harbor requirements.
- If a business has tangible property that is used both within and outside an Opportunity Zone, can that property qualify as Opportunity Zone Business Property? Yes. As long as a business’s tangible property is used within an Opportunity Zone for at least 70% of total use of such property by the business, then the tangible property may qualify as Opportunity Zone Business Property. The Proposed Regulations also clarify that inventory or raw materials in transit from a vendor to the QOZB, or inventory in transit from the QOZB to the customer will be treated as located in an Opportunity Zone.
- If a QOZB that conducts some of its business outside of an opportunity zone, can the business still qualify as a QOZB? Yes, as long as at least 50% of the QOZB’s income is derived from an active trade or business in an Opportunity Zone. The Proposed Regulations provide four methods in which a QOZB can determine whether it meets the 50% active trade or business requirement. First, a QOZB satisfies the 50% requirement if at least 50% of the services performed for the business, as measured by the number hours, are performed in an Opportunity Zone. The calculation includes services performed by employees, independent contractors, and employees of independent contractors. Second, a QOZB satisfies the 50% requirement if at least 50% of the services performed for the business, as measured by the total amount paid by the QOZB for such services, are performed in an Opportunity Zone. The calculation includes services performed by employees, independent contractors, and employees of independent contractors. Third, a QOZB can satisfy the 50% requirement if the tangible property of the business located in an Opportunity Zone and the management or operational functions performed in an Opportunity Zone are each necessary for the generation of at least 50% of the gross income of the business. Fourth, a QOZB may meet the 50% requirement if, based on all of the facts and circumstances, at least 50% of the gross income is derived from the active conduct of business in an Opportunity Zone. It is anticipated that the first two methods will be most utilized due to clarity and ease of administration in the calculations.
- If a business’s assets consist primarily of intangible property (such as software or IP), can it still qualify as a QOZB? Yes, as long as at least 40% of the intangible property is used in the active trade or business of the QOZB in an Opportunity Zone. Moreover, because the 70% Asset Test is based on tangible property, and not all property, the amount of intangible property of a QOZB in relation to the total value of all of its property is irrelevant.
- If a QOZB or QOF uses debt in its financing structure, can the QOZB or QOF make distributions prior to the basis adjustments described in the OZ Statute? Generally, yes. The Proposed Regulations directly allow for debt-financed distributions. Debt-financed distributions are not considered “inclusion events” and will not cause recognition of an investor’s deferred gains. This concept highlights the importance of having some portion of debt in the capital stack for most projects. However, distributions made within 2 years of a contribution could implicate the “disguised sale” partnership rules, causing a deemed sale for tax purposes. Accordingly, extreme caution should be exercised when considering any distributions within 2 years of a capital contribution.
- How is leased property treated for purposes of qualifying a QOZB or QOF? The treatment of leased property was one of the most significant areas addressed by the Proposed Regulations. In general, leased property will be treated as OZ Business Property if it is leased pursuant to an arms-length, market-rate lease agreement that was entered into after December 31, 2017. Leased property is valued, for purpose of the QOZB or QOF asset test, by calculating the present value of the lease payments due under the lease agreement (more details on the calculation method are provided in the Proposed Regulations). In the case of a lease of property from a related party, there are several additional requirements that apply including a limitation on prepayments under the lease, original use of the property subject to the lease, and a requirement that the QOZB or QOF spend additional capital on other tangible property (this looks much like the substantial improvement test). Such additional requirements are intended to prevent abusive related-party transactions.
- Does land qualify as OZ Business Property for purposes of the asset tests for QOZBs and QOFs? Generally, yes. As long as unimproved land located in an Opportunity Zone is acquired by purchase from an unrelated party after December 31, 2017, then the land is not required to be substantially improved to be qualified opportunity zone business property. However, the land must be used in the trade or business of the QOZB or QOF, and there is an anti-abuse rule to prevent “land banking” or similar arrangements by a QOF or QOZB.
- How about vacant or abandoned buildings? As discussed in our previous posts, tangible property must be “original use” or “substantially improved” to be OZ Business Property. The Proposed Regulations relaxed the “original use” requirement for vacant and abandoned buildings. The Proposed Regulations provide that, if any tangible property, including a building, that is vacant or unused for an uninterrupted period of at least 5 years, then such property will be treated as “original use” when it is next placed in service by a taxpayer.
- If my land straddles an Opportunity Zone, can it still qualify for the Opportunity Zone benefits? In the case of real property that straddles an Opportunity Zone, if the amount of real property based on square footage that is located within an Opportunity Zone is “substantial” (which is not defined) compared to square footage of the part of the land outside of an Opportunity Zone, then the real property will be deemed to be located within an Opportunity Zone. The real property outside of the Opportunity Zone must also be contiguous to part or all of the real property inside the Opportunity Zone to receive the benefit of the foregoing rule.
- Is owning and leasing of real property subject to a triple-net lease considered an active business? No. The Proposed Regulations confirmed the position of most tax practitioners – that ownership and operation of a property merely by entering a triple-net lease is not considered active trade or business by the property owner. This distinction is important for purposes of qualifying as a QOZB due to the requirement that 50% of gross income be derived from an active trade or business, but does not affect QOFs.
A variety of unresolved issues remain outstanding including QOF reporting requirements, taxation of interim gains, and the application of certain rules in the Proposed Regulations. Nonetheless, the Proposed Regulations provide much needed clarity for investments in operating businesses, address leasing and other real estate activities, and offer additional flexibility for QOFs.
For more information or the latest update on guidance related to Opportunity Zones, please contact a member of Maynard Cooper’s Opportunity Zone team today.